Has macroeconomics — really — progressed?

25 August, 2015 at 09:32 | Posted in Economics | 3 Comments

A typical DSGE model has a key property that from my work seems wrong. A good example is the model in Galí and Gertler (2007). In this model a positive price shock—a ‘‘cost push” shock — is explosive unless the Fed raises the nominal interest rate more than the increase in the inflation rate. get-off-your-assumptionsIn other words, positive price shocks with the nominal interest rate held constant are expansionary (because the real interest rate falls). In my work, however, they are contractionary. If there is a positive price shock like an oil price increase, nominal wages lag output prices, and so the real wage initially falls. This has a negative effect on consumption. In addition, household real wealth falls because nominal asset prices don’t initially rise as much as the price level. This has a negative effect on consumption through a wealth effect. There is little if any offset from lower real interest rates because households appear to respond more to nominal rates than to real rates. Positive price shocks are thus contractionary even if the Fed keeps the nominal interest rate unchanged. This property is important for a monetary authority in deciding how to respond to a positive price shock. If the authority used the Galí and Gertler (2007) model, it would likely raise the nominal interest rate too much thinking that the price shock is otherwise expansionary. Typical DSGE models are thus likely to be misleading for guiding monetary policy if this key property of the models is wrong.

Ray C. Fair

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3 Comments

  1. As I indicated, great piece.

  2. […] Source: Has macroeconomics — really — progressed? | LARS P. SYLL […]

  3. I was referring to the article by Fair.


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